This article looks at the tax and accounting issues which non-US businesses typically face when they are expanding into the US market. For many businesses, the US market can represent the biggest single opportunity and for tech businesses in particular the growth in the US can be staggeringly quick. It is important to set the right framework for your US expansion at the start as early mistakes can be costly and take a lot of management time to rectify. For those who are unfamiliar with the international aspects of taxation and US tax in particular, there may be new concepts to understand and there will undoubtedly be a lot of forms to complete.
At Frazier & Deeter, our aim is to guide you through the system and make sure you are set up with a robust and tax efficient structure which allows you to make the most of the market opportunity. The article is written from the perspective of a UK company expanding into the US, but the same principles apply to companies based in other countries.
Do You Need a US Subsidiary?
One of the first questions to consider is whether or not you even need to set up a subsidiary company in the US. If you are simply selling to US customers in the US and have limited or no physical presence, then a subsidiary may not be required. In many instances the trigger point for creating a subsidiary is the desire to employ someone locally. Even if you don’t have a subsidiary, you could still have sales or state corporate income tax obligations in the US. Also, if you have some kind of physical presence in the US or if there is someone concluding contracts on your behalf in the US, it is likely you have also created a taxable presence in the US for federal corporate income tax purposes.
Once You Have Decided to Set Up a US Subsidiary
The creation of a US subsidiary will immediately bring you within the US tax net. The tax matters to be addressed can be divided between the routine matters – including registrations, annual compliance and annual returns – and the planning/advisory matters. For most businesses entering the US market, the main planning/advisory areas to consider are Transfer Pricing, State taxes (including Sales and Use taxes) and Global Mobility (the tax consequences of having people move to/from the US on short-term or long-term assignments).
The choice of entity in the US can have a bearing on your tax position and should be discussed with both your lawyers and your tax advisors. The most common form of entity established by non-US parent companies is the Delaware incorporated C corporation. Note that the state of incorporation is not driven by tax considerations – it is a function of corporate law considerations. Other alternatives to the C corporation include a Limited Liability Company (“LLC”) and, on extremely rare occasions, an S corporation.
Obtaining an Employer Identification Number (EIN)
Once the company has been formed, the first thing to do from a tax perspective is to register with the federal tax authorities. This is done by applying for an EIN. The mechanism for doing this is somewhat old fashioned and involves fax machines and special phone lines that are only open to registered agents. The form itself is relatively straightforward, but if you fill any part of it incorrectly then it can take a while to sort it out once it has been submitted. The process of obtaining an EIN normally takes a couple of weeks, but until you have the EIN you will not be able to open a bank account or set up a payroll. The EIN also triggers the registration for Federal and State income tax in the US. Once you have this, you are very much in the system.
Establishing Your Operating Model
A key next step is to decide on your operating model for the US company. Will it be contracting with your customers in the US, or will the company just be used to provide support services back to the parent company? Often the decision regarding which entity will be the contracting entity with the US customers will be driven by commercial and legal considerations. The choices you make will have an impact on the tax position.
At this stage, it is really important to think about the transfer pricing ramifications of your operating model. The transfer pricing rules and guidelines in both the US and parent company location will be used to determine how future profits and losses will be allocated between the US and the parent company. This isn’t an exercise you can ignore until the group is making an overall profit – the operating model you set up at the start will determine the basis for the future profit sharing. In many cases, the US will expect a taxable profit to be allocated to it from day one even where the group is in an overall loss position. Spending a small amount of time up front deciding on the operating model and documenting it in a way that will be respected by both sets of tax authorities will avoid time consuming and costly tax enquiries. It will also enable you to determine an efficient tax strategy for your international expansion.
If you decide that your US company will be the contracting entity with your US customers there are still a number of decisions to be made about your operating model and the approach to transfer pricing:
- Will the US act as a full-risk distributor or should it be a limited risk distributor?
- Should it pay a royalty back to the parent company to reflect the intangible assets that have been generated there, or would it be better to fix the remuneration for the US in some other way – for example as a percentage of revenues or as a mark-up on costs?
- Is the US entity acting more as an agent for the parent company?
Beyond deciding on the operating model and transfer pricing policy, there are two other key matters to deal with as part of this exercise:
- Firstly, whichever model is chosen there will need to be an exercise carried out to determine the pricing used. The IRS in particular are likely to insist on a benchmarking exercise for most intercompany transactions – this involves accessing specific databases of comparable pricing information so the pricing chosen for your transactions between the US subsidiary and the parent company can be justified.
- Secondly, you will need to get support from your lawyers in creating legally binding intercompany agreements. Without these, there is no legal basis for making the intercompany payments.
In an ideal world the operating model and transfer pricing arrangement should be supported by OECD format transfer pricing documentation (known as a Master File and Local File). For smaller companies that are going international for the first time, it may be acceptable to leave this documentation until a later stage.
State and Local Taxes
It comes as a surprise to many that the tax system in the US is not a single federal system. Each of the 50 states has its own tax system and in theory any of the more than 3,000 counties could levy its own local taxes. One important point to note is that state and local taxes are not covered by double tax treaties. For example, if a UK company is trading in the US and under the UK/US double tax treaty the right to tax those profits are given to the UK, then although this would stop US federal taxes being charged, it would not prevent state income tax from being due. This point can easily be overlooked. In practice, the main taxes that need to be considered at the state level are income taxes, sales taxes and property taxes.
State Income Taxes
State income taxes are typically in the region of 6%, but can be as high as 12%. Most states will levy the tax on the same tax base (with some adjustments) on which the federal income taxes are charged with the state primarily looking for an apportionment of the taxable profits. For example, if the taxable profits of the US company are $100 and 12% of the profits are deemed to be attributable to the state of Georgia, then the IRS will collect the federal tax on the $100 of profits and the state of Georgia will receive the state income tax on $12 of the profits. Other states may also get a share of the profits, but there is no requirement for the total taxable profits of all the states to add up to $100 – as each state has its own way of deciding whether the taxable profits are linked to that state then the total could add up to more or less than the $100.
You often hear accountants in the US talking about “nexus” when dealing with state taxation – this is a reference to whether or not there is a sufficient connection with any of the states in order for the profits to be taxable in that state. State income tax returns need to be filed each year and are a separate filing requirement to the federal income tax returns. In theory, a company that trades extensively across the US could have many state income tax returns to submit each year. In practice, they tend to be much simpler returns than the federal income tax returns.
These are often described as the US equivalent of VAT or GST. However, there are some very important differences. In particular, there is no ability to recover input taxes in the way you can with VAT if you are a taxable business. If someone charges you sales tax on a purchase, then it will be a cost to you. Secondly, there will be many instances where sales taxes are not due on a transaction. Typically, sales taxes will only be charged on sales of tangible, personal property to an end user – so if you are buying goods for resale or if you are buying/selling services, then there is unlikely to be any sales tax in the US. It is not quite as simple as it sounds as roughly half the states in the US also treat SaaS (Software as a Service) as subject to sales tax.
If you are selling in the US (whether you are a US company or a non-US entity), then you will need to determine if you have sufficient “nexus” with a state for sales tax to be due. In the old days, this was mostly based on physical presence in the state. However, following the Supreme Court decision in 2018 known as the “Wayfair” ruling, states can still force you to collect sales tax even if you do not have a physical “nexus” in that state. Instead, we now need to focus on the concept of “economic nexus” which usually revolves around the value of sales you have made in that state in a particular year.
Customers in the US usually expect prices quoted to exclude sales taxes and generally accept them being added on the sales price at the point of sale. The trader is simply regarded as the collecting agent for the state tax authority. The risk for new entrants into the US market is that they don’t realise they should have been collecting sales tax on various sales and then it gets uncovered on an enquiry. By that point, it is too late to go back to your customers and ask them to pay over the sales tax that was due, so it becomes an absolute cost to the trader. The answer is to make sure you get good advice on your sales tax obligations up front so you know you are collecting and handing over any sales tax that is due.
Many states impose a business tax on the value of a company’s tangible personal property [equipment, furniture, etc.] and include inventory in the tax base. While oftentimes these taxes may have exemptions or not result in significant amounts of tax liability, you should be aware of potential reporting requirements and related liabilities.
Annual Tax Returns in the US
Federal corporate income tax returns are normally due three months and 15 days after the end of an accounting period, but this deadline can be extended if requested. Companies are free to choose their accounting period in the US, but it is typically aligned to the accounting period of the parent company. State corporate income tax returns deadlines usually follow the federal due date.
Unlike the UK, where there is an annual requirement for companies to file financial statements at Companies House, there is no requirement in the US for private companies to prepare or publish financial statements. This means that your tax advisers in the US are able to prepare income tax returns based on either management accounts or a trial balance – either of which could be kept by your accounting team in the UK.
Some states in the US impose a Franchise Tax on companies that have nexus in that state. This is essentially an annual fee for the privilege of being able to do business in that state. For example, in Delaware the Franchise Tax for “C corporations” is based on the number of authorised shares of the company – if there are 5,000 or fewer authorised shares then the annual fee is $175 and if there are between 5,001 and 10,000 authorised shares the annual fee is $250. The fees increase for companies with more than 10,000 authorised shares. Typically, companies will either handle these Franchise Taxes themselves, or if they have a presence in a number of states were these taxes are due then they may engage with a corporate agent to look after the returns for them.
There are many official forms which may need to be completed by companies doing business in the US. These include forms such as the W8- BEN- E – which would typically be required if you are trading in the US as a non-US company – or the form 5472, which is required for reporting particular activities with foreign related companies. It is hard to keep track of all the different forms and when they need to be completed, so make sure you engage with an advisor who can provide a more supportive service and who will let you know about requirements that may be new territory.
Mind the GAAP
There are subtle differences between IFRS and US GAAP which can lead to significant differences in revenue recognition. The introduction of ASC 606 in 2018 for public companies and 2019 for private companies changed the landscape for businesses in the technology sector. When you are putting together information for a tax return in the US, it is essential that you start with the correct figure for revenue. It is also important to be on top of revenue recognition. If you are considering finance raising in the US – potential investors can quickly lose confidence in a business if they find errors in the approach to revenue recognition.
If you are employing people in the US, then you will need to engage with a payroll services provider to operate the payroll and account for the correct amount of payroll withholding taxes to the IRS and the state tax authorities. There are many, very capable payroll services providers who can do this for you, but none of them will be able to start operating the payroll until the EIN has been obtained. If you have plans for setting up and employing people in the US, it is worth thinking through the timeline and making sure you will be able to get everything set up in time.
As you expand your US operations, you may want to offer stock options to senior employees based in the US. It is perfectly acceptable to offer options over shares in the UK parent, but real care needs to be taken with the valuation of the options. A grant of an option at an undervalue can have significant tax consequences for the employees in the US. Many UK companies are unaware that the IRS have a significantly different approach to valuing options when compared to HMRC. The approach used by the IRS is known as a section 409A valuation and we would always recommend that this kind of valuation is carried out before issuing options to anyone based in the US.
Given the significance of the US as a market opportunity for many UK businesses, it is common for founders to want to spend some time in the US or send over some of their senior UK team to ensure that they make the most of the opportunities there. This could be in the form of short-term business trips or a longer-term secondment or transfer. As well as sorting out the visas, there are a number of tax matters which need to be considered. Firstly, for the individual, will they be in the US long enough to become tax resident there and will they lose their UK tax resident status? What happens if they end up being tax resident in both countries – which country will have the taxing rights? How would a temporary change of tax residence affect other sources of income or other assets which the individual might hold?
The companies will need to consider what they want their policy to be for these employees – do they want to compensate them for any additional tax charge which the employees will incur as a result of the relocation? The companies will also need to be aware of any reporting or payroll withholding obligations they may have for internationally mobile employees – whether they are going from the UK to the US or if you are bringing US employees back to the UK for a short business trip. For example, in the UK there can be a requirement to operate PAYE on an apportioned part of the salary of a business visitor from your US subsidiary – even if they are in the UK for just one day. This can be avoided by entering into a particular form of agreement with HMRC where the UK employer commits to providing certain information on overseas visitors on an annual basis.
Note that from the US standpoint, while the employee may not have a federal personal income tax return filing requirement, the company may still have payroll tax withholding requirements. If there is no federal payroll tax withholding requirement, there may still be a state payroll tax withholding requirement. Also, while the individual employee may not have a federal income tax reporting requirement, they may still have a state income tax reporting requirement. An early conversation with a specialist who is used to UK/US mobility can quickly identify any areas which need to be addressed.
Inversions (or the Delaware Flip)
As well as the market opportunity, a major attraction of the US for UK companies is the access to investors. Many of these investors will only consider investing in a US top company, so there needs to be a mechanism for inserting a US company above the existing UK top company. The usual approach is to create a new US company and then the existing shareholders of the UK top company will transfer their shares in the UK company to the new US company in exchange for an issue of shares by the new US company. The new US company can then issue more new shares to the new investors for cash. This is known as an inversion, or “flip”. There are a number of tax considerations to understand regarding an inversion. Firstly, you will want to make sure that the inversion does not trigger either a capital gains tax charge for the existing investors on their “disposal” of the shares in the UK company. Secondly, you will want to ensure there is no charge to stamp duty land tax on the restructuring. Both these objectives should be easy to achieve provided the right approach is taken. Future investors will be keen to ensure that they are not investing in a company which has a potential problem, so it is advisable to seek the appropriate clearances from HMRC on these matters to ensure the restructuring does not cause any problems during a future due diligence exercise by a potential investor or acquirer.
If the UK company has business angel investors who have benefitted from either Enterprise Investment Scheme (EIS) relief or Seed EIS relief then the inversion can be more complicated. It is still very feasible to invert without the investor losing any of their valuable reliefs, but you will need to be much more careful with the restructuring to ensure everything happens in the right order. We would strongly recommend working with a law firm and an accounting firm that have good experience in this area if you are considering an inversion.
For many businesses, the establishment of a US subsidiary will be their first step towards creating an international group. The tax complexities of setting up in the US are compounded by the combination of federal and state tax systems. The potential rewards from getting it right in the US are enormous for many businesses, but it is easy to fall short. If you don’t pay proper attention to all of the tax and accounting considerations when you enter the market, then it can be very costly and time-consuming to sort things out at a later date. A good firm of advisers should be able to hold your hand throughout the process – highlighting areas you may not have thought about as well as responding to any questions you may have.
When it comes to international expansion, a proactive approach is always best. The tax and business advisers at Frazier & Deeter can support businesses and employees with their international tax and accounting needs. Get in touch if you’d like to schedule an informal call to discuss your international growth.
About the Authors
Malcolm Joy is the leader of Frazier & Deeter’s UK practice, as well as the firm’s Transfer Pricing team. Mike Whitacre is a Tax Partner with Frazier & Deeter based in Atlanta who works with many multi-national organisations.
- Malcolm Joy – Malcolm.Joy@frazierdeeter.com
- Mike Whitacre – Mike.Whitacre@frazierdeeter.com